Ask the Institute

DATE: October 21, 2013QUESTION:Recently, the VIX® index rose from 16.75 to 19.00, but the VIX November 15 Call only rose to 3.50. It was then trading at 50 cents under parity. Can you explain how this can happen?

ANSWER:If you trade VIX options, it is important to know about their unique pricing characteristics.

VIX options settle to the VIX Index at expiration. However, prior to expiration traders are looking at VIX futures prices, not the VIX Index.

Market makers in stock options hedge their options trades with the underlying stock. In contrast, market makers in VIX options hedge their VIX options trades with VIX futures contracts, because the VIX Index cannot be traded like a stock.

For this reason, prices of VIX options sometimes seem to be "unusual" relative to options on stocks. VIX options can trade below parity if VIX futures are trading at a deep discount to the VIX Index. VIX options can also trade at seemingly astronomical premiums if the VIX futures are trading significantly higher than the VIX Index.